Shock reaction to BOJ bond buying cut makes stimulus exit a challenge

January 15, 2018

TOKYO- When Japan’s central bank made a small cut to its regular bond purchases this week, what should have been an unremarkable market operation to manage monetary policy shot the yen and bond yields higher as investors began to price in a rapid exit from crisis-era stimulus.

The operation wasn’t a signal of a policy change--the officials in charge have no such mandate--and wasn’t intended to shock markets, which up till now had barely reacted to a very gradual reduction in bond purchases over the past four months.

But the reaction was a wake-up call for Bank of Japan policymakers that telegraphing future plans to dial back stimulus will be trickier than first imagined, despite a broadening economic recovery. Miscommunication could trigger unintended consequences, notably an unwelcome yen spike.

People familiar with the BOJ’s thinking say while the bank sees no need to change the way it conducts market operations, it will likely calibrate its policy message more carefully to remind markets it is no rush in withdrawing monetary support.

“The market reaction was a surprise for the BOJ,” one of the sources said.

“The last thing the BOJ wants is to spark a sharp yen rise that could cool sentiment,” another source said, a view echoed by two other sources.

Japan is not alone in facing communication challenges. The Federal Reserve and the European Central Bank are also grappling with how to exit extraordinary policy measures, without scaring investors accustomed to years of massive cheap money.

Global bond yields hit multi-month highs and the yen rose more than 1 percent against the dollar this week, as Tuesday’s reduction in bond buying sparked speculation the BOJ could start to withdraw stimulus this year.

While many in the BOJ see the reaction as a one-off move driven mostly by speculators, it highlighted how sensitive markets are to a pullback in the huge stimulus that has been the centerpiece of premier Shinzo Abe’s “Abenomics” policies.

“2018 looks to be an important year for the BOJ and the financial markets as the first year of normalization,” said Tetsufumi Yamakawa, chief economist at Barclays Securities Japan, who expects the central bank to tweak its yield target sometime during the July-September quarter.

Deflation has been more entrenched in Japan than any other major economy, as two decades of price falls forced companies to cut prices to lure consumers and discouraged them from boosting investment. Wages remain low, keeping households from spending.

Four years of heavy money printing have failed to drive up inflation to the BOJ’s 2 percent inflation target, keeping alive expectations the BOJ will lag well behind its US and European peers in exiting crisis-era policies.

Despite signs of economic momentum, retailers and restaurant chains are struggling to lift prices for fear of losing customers conditioned by nearly two decades of deflation.

The market rout also came as the BOJ faces a leadership change with Governor Haruhiko Kuroda and his two deputies ending their five-year terms in April and March, respectively.

Abe, who will nominate their replacements, has praised Kuroda, but expressed his desire to see the BOJ maintains its massive stimulus that helped weaken the yen and boost the export-reliant economy.

Still, the rising cost of prolonged easing, such as the hit of near-zero rates on bank earnings, has prompted the BOJ to drop subtle hints it could edge away from its extremely accommodative stimulus earlier than expected.

Some policymakers hope that if inflation sustainably exceeds 1 percent later this year, the BOJ could start signaling the path toward a future exit from easy policy, the sources say.

The BOJ also has little choice but to keep slowing its huge bond buying, which is drying up liquidity and has already made the bank the owner of almost half the market, analysts say.

That means the BOJ could trim bond buying again and explain it as a technical step without policy implications, the sources say.

But it is uncertain whether the BOJ can do so without unnerving markets by stoking fears of an early exit.

The BOJ is wary of repeating what critics saw as a premature end to quantitative easing in 2006 that is blamed for prolonging deflation, and the political fury it suffered for failing to tame a damaging yen spike in 2011, the sources say.

“Currency market moves are harder to predict for the BOJ than bond market moves, which it has stronger influence over,” a third source said.

If currency players begin to focus more on the BOJ’s slowing bond purchases, it could discourage policymakers from openly debating an exit, the sources say.

It could also push back any plan to remove a loose pledge to keep buying bonds at an annual pace of 80 trillion yen ($720 billion), even though actual buying has already slowed to nearly half that pace.

“The best approach may be to stay quiet until the dust settles,” a fourth source said. “For the BOJ, there is no harm waiting for the right timing.” – Reuters

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